Inflation and the National Debt: Delayed Reckoning

Image created by Canva's Dream Lab, an AI tool

The U.S. economy faces potential vicious cycles as mounting national debt and servicing costs could trigger economic downturns, with the Federal Reserve caught between controlling inflation and maintaining employment. While the recent inflation surge is subsiding, the path forward requires difficult choices between short-term stability and long-term solutions like growth-promoting reforms, tax increases, and spending cuts—yet politicians show little vision or appetite for these necessary measures.

Four and a half years ago, I wrote on this blog that high servicing costs from rising national debt, inflation, and even crisis and collapse were all greater long-term concerns than the immediate economic effects of COVID-19. I predicted inflation was the most likely concern in the medium term. The predicted surge in inflation came, but the wave is now subsiding. But we are not out of the woods—the risk of vicious cycles remains in several ways.

High Servicing Costs

As debt piles up, investors eventually worry that the level of debt and the cost of servicing it is becoming unsustainable. This causes them to shift investments away from that debt, which causes interest rates to rise. The rising rates make servicing that debt harder, potentially sparking a vicious cycle of increased investor wariness and moves away from that debt and rising interest rates and servicing costs.

Because government bonds are considered “risk free,” rising interest rates on them trigger rising rates on debts elsewhere. The effect is that fewer people, companies, and governments are able to afford to issue debt and saving money becomes relatively more attractive than spending it. This leads to an economic downturn.

There are two ways to address the above risks: paying down the debt and artificially lowering interest rates. The former is the long-term solution to a debt crisis, but in the short term, it can actually make a crisis worse: In the case of the government, it would mean cutting spending and/or raising taxes just as the economy is weakening, exacerbating the downturn. As the economy shrinks, the debt level relative to GDP rises, making the debt even more unsustainable—yet another vicious cycle.

The alternative is for the central bank (the Federal Reserve or “Fed” in the US) to artificially lower interest rates by buying up government (and potentially other types of) bonds. The bank essentially funds the excessive government spending, relieving the pressure to cut spending and raise taxes and making borrowing cheaper and spending and saving more and less attractive, respectively, boosting the economy.

The problem with this approach is the potential for another surge in inflation. If the economy is in recession and inflation is trending downwards, the central bank can cut interest rates to boost the economy and ease borrowing without boosting inflation. Inflation has been higher than targeted for the past several years, however, so the central bank may not be as free to cut interest rates as it was during the disinflationary 2000s, and 2010s. If the Fed and other central banks stay true to their inflation targets, debt servicing costs could remain high while economies get mired in recession. This combination of stubborn inflation and economic stagnation was dubbed “stagflation” when it last occurred in the 1970s.

Resurgent Inflation

Will the Fed and other central banks stay true to their inflation targets? This is less certain than it once was for the Fed, whose inflation target is set by the bank itself*, not anchored in statute as it is for many other rich-world central banks. Politicians throughout the rich world, including in the United States, have shown a much higher tolerance for deficits and, until recently, were not as worried about inflation as leaders in the 1970s through the 1990s were. Inflation is considered a big factor in Kamala Harris’s election loss, so we might conclude that politicians will now be wary of inflation and do what it takes to avoid it, but the jaws of stagflation may soften their resolve.

As noted above, inflationary pressure may occur at the same time as high debt servicing costs are pushing the economy into recession. The Fed has a dual mandate to focus on controlling inflation while ensuring “maximum employment.” In a stagflationary environment, which opposing goal will the Fed choose? This may depend on sentiment among politicians in Washington, and from President Trump in particular. Trump’s unconventional economic views make predicting how he would react impossible, but this author suspects he would accept higher inflation to avoid (temporarily) a deeper recession.

No Shortcuts

Choosing inflation over recession is not a long-term solution. Stagnation will continue as inflation hollows out the economy. Over the long term, growth-promoting reforms that boost employment and the supply of key goods (thereby reducing their cost and easing inflation), combined with tax increases and spending cuts to stabilize the debt burden are the only way out. At the moment, few politicians in America and Europe are making proposals that would accomplish this, meaning we can expect the crisis to be deferred and, when it hits, to drag on until politicians and voters find the right solutions and are willing to shoulder the costs of implementing them. In a later post, I’ll describe how tackling the cost-of-living crisis with supply-side reforms to three key areas—housing, health care, and education—could boost growth by acting as a tax cut on American consumers and businesses (not to mention making them happier).

*The Fed has a legal mandate to maintain “stable prices,” but it is not guaranteed that “stable prices” will always mean “inflation of around 2%.”